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Biggest risk to ethanol margins may be price of gasoline

Elton Robinson Farm Press Editorial Staff | Apr 28, 2006

The biggest risk for ethanol producers over the next 10 years is when ethanol prices drop in response to gasoline prices, according to an analysis by the Food and Agricultural Policy Research Institute at the University of Missouri. The report indicated that the price of corn had a lesser effect on ethanol producer profitability.

FAPRI, USDA and the Congressional Budget Office all project rapid growth in the amount of corn used for ethanol production through 2016. All three estimate corn use for ethanol at around 1.5 billion bushels for 2005-06, and increasing to over 2 billion bushels by 2007-08. All three expect corn use for ethanol to almost double from current levels by 2016, to roughly 2.9 billion bushels annually. The analysis assumes the continuation of current farm and energy policies.

Over the next 10 years, ethanol production is expected to increase from 3.89 billion gallons annually to 8.1 billion gallons annually. Use is expected to keep pace with supply with ethanol ending stocks increasing from 250 million gallons to 493 million gallons during that time.

Ethanol production alone is expected to easily exceed the entire renewable fuels use mandated by the Energy Policy Act, which calls for annual increases in production of renewable fuels by 700 million gallons through 2010.

If ethanol production does indeed exceed the renewable fuel mandate, ethanol will need to be price-competitive with gasoline, according to the analysis. FAPRI projections, which are based on reports from the forecasting company Global Insight and other sources, indicate ethanol and gasoline prices are likely to decline from 2006 levels — in the long term, that is.

“If you look at current futures prices for petroleum, you would have a higher price path than the one we have here,” said Pat Westhoff, a FAPRI economist. “But Global Insight still hasn't significantly modified its projections for prices once you get past year two of the analysis. It doesn't mean they won't change their mind sometime in the future though.”

Considering only two major products from ethanol production (ethanol and distillers grains) and two major inputs (corn and natural gas), ethanol gross margins are at record levels this marketing year. Dried distillers grain is the product obtained after the removal of ethyl alcohol by distillation.

The estimated value of ethanol in 2005-06 is $2.10, which includes a value for ethanol of $1.86 per gallon at the plant and a value of DDG at 24 cents per gallon. Subtracting the corn cost of 70 cents per gallon and a natural gas cost of 33 cents per gallon produces the record gross margin of $1.07.

The FAPRI report indicates gross margins will decline by 27 cents per gallon between now and 2016, but remain high by historical standards. Ethanol prices are projected to decline by 14 cents per gallon, while distillers grain prices remain about the same.

The analysis suggests that projected corn prices will increase 57 cents per bushel, increasing ethanol costs by 13 cents per gallon by 2016. Natural gas costs are projected to decline relative to the high levels of the final months of 2005.

FAPRI also looked at 500 alternate futures plugging in unknowns such as weather, the price of corn, the price of petroleum, etc. Models indicate a risk of low margins for ethanol producers in 10 percent of the outcomes.

The projected gross margin for ethanol drops to about 78 cents per gallon in 2012-13, before rising to 80 cents by 2016. However, in the low margin outcomes, the average gross margin was 38 cents per gallon, about the same as the 1997-98 margin — the lowest margin in the last 10 years.

The analysis indicates that the biggest risk to ethanol gross margins is the price of ethanol. In the 50 outcomes with the lowest gross margins, the average ethanol price was 34 cents per gallon below the average projected price. These low ethanol prices were in turn associated with low unleaded gasoline prices.

Corn prices were also higher in those outcomes with low margins, but the corn price only accounted for 9 cents per gallon in reduced margins.

The analysis suggests that margins are most likely to be lowest when unleaded gasoline and ethanol prices are well below average. Corn prices also play a role, but ethanol prices are a more important factor in explaining low margins than are high corn prices.

Ethanol prices at the plant typically exceed those of unleaded gasoline, but the 51-cent per gallon tax benefit for ethanol makes it price-competitive at the pump. For example, in 2007, ethanol is projected to be priced 22 cents higher at the plant than unleaded gasoline. With the tax credit, ethanol would be priced 29 cents lower at the pump.

Over the past 10 years, U.S. corn used for ethanol has increased from 533 million bushels annually to 1.32 billion bushels estimated for 2004-05.